Accounting for Derivatives. Ramirez Juan

is made in the currency of denomination of the financial asset.

      Contractual Cash Flows Test – Modified Economic Relationship

      IFRS 9 also refers to the case of “modified economic relationships”. For example, a financial asset may contain leverage or an interest rate that is resettable, but the frequency of the reset does not match the tenor of the interest rate (an “interest rate mismatch”). In such cases, the entity is required to assess the modification to determine whether the contractual cash flows represent solely payments of principal and interest on the principal amount outstanding. To do this, an entity considers cash flows on a comparable or benchmark financial asset that does not contain the modification. The benchmark asset is a contract of the same credit quality and with the same contractual terms (including, when relevant, the same reset periods), except for the contractual term under evaluation (i.e., the underlying rate).

      If the modification results in cash flows that are more than insignificantly different from the benchmark cash flows, or if the entity is unable to reach a conclusion, then the financial asset does not satisfy the SPPI test (see Figure 1.3).

      In making this assessment the entity only considers reasonable possible scenarios rather than every possible scenario. If it is clear with little or no analysis whether the cash flows on the financial asset could or could not be more than insignificantly different from the benchmark cash flows, then an entity does not need to perform a detailed assessment.

      Example: Constant maturity swap

      A constant maturity bond with a 5-year term pays a variable rate that is reset semiannually linked to the 5-year swap rate. The benchmark cash flows are those of an otherwise identical bond but linked to the 6-month rate. At the time of initial recognition, the difference between the 6-month rate and the 5-year swap rate is insignificant. This bond does not meet the SPPI requirement because the interest payable in each period is disconnected from the term of the instrument (except at origination). In other words, the relationship between the 6-month rate and the 5-year swap rate could change over the life of the instrument so that the asset and the benchmark cash flows could be more than insignificantly different.

1.1.3 Financial Assets at Fair Value through Other Comprehensive Income

      This category consists of debt investments that meet the contractual cash flows test, for which their business model is held to collect and for sale. This is a mandatory classification, unless the FVO is applied. This category is intended to acknowledge the practical reality that an entity may invest in debt instruments to capture yield but may also sell if, for example, the price is considered advantageous or it is necessary to periodically adjust or rebalance the entity's net risk, duration or liquidity position.

      This category also consists of equity investments which are not held for trading. An entity can choose to classify non-trading equity investments in this category on an instrument-by-instrument basis. This is an irrevocable election.

1.1.4 Financial Assets at Fair Value through Profit or Loss

      The FVTPL category is in effect the “residual category” for instruments that do not qualify for the amortised cost or FVOCI categories. The following financial assets would be included in the FVTPL category:

      • financial assets held for trading;

      • financial assets managed on a fair value basis to maximise cash flows through the sale of financial assets such that collecting cash flows is only incidental;

      • financial assets managed, and whose performance is evaluated, on a fair value basis;

      • financial assets where the collection of cash flows is not integral to achieving the business model objective (but only incidental to it); and

      • financial assets that fail the SPPI test.

      Derivatives are recognised at FVTPL unless they are a hedging instrument in cash flow hedge or net investment in foreign operation. Therefore, derivatives undesignated or being hedging instruments in fair value hedging relationships are classified at FVTPL. Recognition of derivatives is covered in detail in Chapter 2.

1.1.5 Financial Assets – Initial and Subsequent Recognition

      An entity recognises a financial asset when and only when the entity becomes a party to the contractual provisions of a financial instrument. The initial measurement of the financial asset is its fair value, which normally is the consideration given, including directly related transaction costs.

      Debt Instruments at Amortised Cost

      Debt instruments classified at amortised cost are subsequently recognised at amortised cost less impairment in the statement of financial position. Interest income and impairment are recognised in profit or loss. Interest income is recognised using the effective interest rate method. Impairment charges can be reversed through profit or loss. Foreign exchange gains and losses are recognised in profit or loss.

      Debt Instruments at FVOCI

      A debt instrument classified at FVOCI is presented in the statement of financial position at fair value. The entity also keeps an amortised cost calculation (i.e., an effective interest rate) to recognise interest income in profit or loss.

      Interest income and impairment are recognised in profit or loss, using the same methodology as for amortised cost. Interest income is recognised using the effective interest rate method. Impairment charges can be reversed through profit or loss. Likewise, foreign exchange gains and losses are recognised in profit or loss as if the instrument were carried at amortised cost. The difference between amortised cost (in the currency of denomination) and fair value (in the currency of denomination) is recognised in OCI and recycled when the instrument is sold.

      Equity Instruments at FVOCI

      Gains and losses on equity investments in this category are recognised in OCI with no recycling of gains and losses into profit or loss. If an equity investment is so designated, then dividend income generally is recognised in profit or loss. No impairment is recognised.

      Instruments at FVTPL

      Gains and losses on instruments in this category are recognised in profit or loss. No impairment is recognised.

      Summary

      The table below gives an overview of the accounting treatment of each category of financial assets:

      Leveraged Financial Assets

      In order to meet the contractual cash flows criterion, there should be no leverage of the contractual cash flows. Leverage increases the variability of the contractual cash flows, with the result that they do not have the economic characteristics of interest.

      Non-recourse Financial Assets

      IFRS 9 contains specific guidance on classifying non-recourse (or limited recourse) financial assets. These assets represent an investment in which the investor's claims are limited to specified assets, which may be financial or non-financial assets. IFRS 9 states that the fact that a financial asset is non-recourse does not mean in itself that the SPPI criterion is not met.

      • If, for instance, the underlying assets meet the SPPI criterion, it may be possible to conclude that the non-recourse asset also meets the criterion.

      • If, for example, the non-recourse asset is a vehicle whose only asset is an equity investment, it will not meet the SPPI criterion.

      Contractually Linked Instruments – Tranches of Securitisations

      IFRS 9 contains specific guidance on classifying contractually linked instruments that create concentrations of credit risk (e.g., securitisation tranches). The right to payments on more junior tranches depends on the issuer's generation of sufficient cash flows to pay more senior tranches. The standard requires a look-through approach to determine whether the SPPI criterion is met. Otherwise, the tranche would be recognised at fair value.

      A tranche meets the SPPI criterion only if all the following conditions are met:

      Principal